A Bad Time To Escalate Border Issues With Mexico

Summary

The markets are unhappy with President Trump's Mexican standoff. That can be seen in both the stock market and the 10-year Treasury yield dropping to 2.14% last week -36 basis points below the Fed funds rate.

The 10-year Treasury yield is not yet below the 2-year note, which is the classic measure of yield curve inversion. The 2-year closed Friday at 2.03%. This is the only silver lining that I can find.

Sharply dropping Treasury yields in a good economy often mean the market is worried that the economy will not be so good a year from now.

However, the junk bond market tends to top out before the stock market in a deteriorating economy. It did not do that in the fourth quarter of 2018, nor is it doing so now.

We were waiting for new tariffs on China and instead got new tariffs on Mexico, a country that has agreed to a new trade deal to replace the old NAFTA. Clearly, using tariffs to resolve immigration issues is an innovative tool, but does it really solve anything?

Many of the immigrants President Trump wants to target come through legal ports of entry claiming asylum. I am not familiar with Mexican immigration laws, but are tariffs a way for Mr. Trump to force Mexican immigration laws to change? This seems to be overreaching a bit.

Not even his infamous Wall would solve the issue of immigrants claiming asylum at U.S. border checkpoints. While negotiating a complicated situation with the Chinese - a trade friction that was frankly overdue and completely warranted - the last thing we need is this added "Mexican standoff."

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The markets are unhappy with President Trump's Mexican standoff. That can be seen in both the stock market and the 10-year Treasury yield dropping to 2.14% last week -36 basis points below the Fed funds rate. The 10-year Treasury yield is not yet below the 2-year note, which is the classic measure of yield curve inversion. The 2-year closed Friday at 2.03%. This is the only silver lining that I can find.

Sharply dropping Treasury yields in a good economy often mean the market is worried that the economy will not be so good a year from now. A big driver of falling yields in the U.S. is the situation in Europe, where the German 10-year bund closed on Friday at -0.20%, while the German 2-year federal note that goes by the uber-long name Bundesschatzanweisungen, closed Friday at -0.64%. The "schatz" bunds have offered negative yields ever since Jeff Gundlach called them the "short of the century" four years ago, so we have very serious issues in Europe if interest rates are stuck in negative territory for so long.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The latest drop in Treasury yields is not all about the situation in Europe, but also the failure of trade talks with China and new sanctions in Mexico. Those trade frictions have not yet turned out to be an economic event, but they have the potential to become substantial disruptors to economic performance in the United States, Mexico, and China - all at the same time - should they escalate further in the latter part of 2019.

Junk Bonds Say Tariffs Are Still Only A Worry, Not a Threat

Markets worry about the future, and sometimes they extrapolate quite a bit further than warranted by actual future events. While junk bond prices have weakened, as they typically are heavily correlated with stock prices, they are not leading the stock market lower. One big difference between now and the fourth quarter of 2018 is that we have much lower Treasury yields this time around, as the market is no longer worried about the Fed overtightening as it was back then.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

It is my experience that the junk bond market tends to top out before the stock market in a deteriorating economy. It did not do that in the fourth quarter of 2018, nor is it doing so now. Junk bond spreads have not "blown out," and junk bond prices are declining coincidentally with the stock market, not leading it.

The way I read this situation is that the tariff issue has not become an economic event yet, but it has the potential to become a big economic event, particularly if the situation with Mexico escalates. It could be that President Trump is merely giving the Mexicans a jolt and does not want to escalate the situation with tariffs. He is famous for putting his opponents in a situation where they never really know where they stand, which would make the Mexican tariffs "a Trump thing to do." We'll find out soon enough.

The way I see it there are three scenarios: 1) Worst case, the situation with Mexico and China blows completely out of control, which I would consider unlikely. 2) Most likely, the situation with Mexico is resolved before it blows out control, but the situation with China continues to deteriorate. I would consider that as a base-case scenario and most likely. It is the calculated failure of the trade talks by China that leads me to believe that they never intended to make a deal, while Mexico did agree to a NAFTA renegotiation. 3) Best case, but unlikely, the issues with both Mexico and China are resolved this summer.

The Sun Tzu disciples in Beijing have been getting away with a clever system of purposefully buying less from the U.S. and more from key partners and neighbors to increase their political influence there, as well as forced transfer of technology, and they would likely want to continue with that system. Plus, a failed trade negotiation gives them the political cover to devalue the yuan, which may be their ultimate goal.

As the old Chinese curse goes: "May you live in interesting times."

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